The Obama administration’s suit against the rating agency Standard & Poor’s makes for
riveting headlines and lousy history. We want to blame the financial crisis and Great Recession on
greed and dishonesty. The charge that S&P rigged bond ratings for its own gain — providing
artificially high ratings on the mortgage-backed securities that inflated the credit bubble — fits
this self-serving morality tale. The discomforting reality is that the financial collapse resulted
from an extended period of prosperity, which led to weakened credit standards and inspired wishful
thinking about the permanence of economic growth.

The administration is asking “in excess of $5 billion” in penalties from S&P, an amount it
says reflects the losses caused by the erroneous ratings. Law professor Jeffrey Manns of George
Washington University notes that the top three ratings agencies — S&P, Moody’s and Fitch —
provide 96 percent of all ratings. A $5 billion penalty might put S&P’s parent company,
McGraw-Hill, into bankruptcy and force S&P to close. A swarm of state lawsuits compounds the
possibility. With many bonds rated by two agencies, Manns wonders whether it would be good public
policy to convert the existing oligopoly into an effective monopoly.

The stakes here are enormous. After reviewing 20,000 pages of documents and emails from S&P,
the Justice Department says that S&P hyped ratings of residential mortgage-backed securities
and collateralized debt obligations to generate business. Banks and investment banks selling the
securities pay for the ratings; higher ratings would attract more buyers. So S&P delayed
introducing new risk models that would have lowered ratings, says Justice. S&P’s advice was
tainted by the pursuit of profits. Each collateralized debt-obligations rating fetched fees from
$500,000 to $750,000.

The suit reflects the conspiracy theory of the crisis: Sleazy bankers, waving distorted ratings,
sold overvalued residential mortgage-backed securities and collateralized debt obligations to
unsophisticated investors. It’s a seductive story contradicted by the facts. As Bloomberg columnist
Jonathan Weil has written, many banks and investment banks that sold these bonds also bought them
for their own portfolios. They thought the bonds had value.

Paradoxically, the financial crisis’ real origins lie in the economy’s good performance and its
corrupting effects on public opinion. By 2007, the United States had experienced only two modest
recessions, 1990-91 and 2001, in a quarter-century. Since 1990, the unemployment rate had averaged
5.4 percent. Economists touted the “Great Moderation,” signifying fewer and milder slumps.

With a more stable economy, risk seemed to diminish. People could borrow more because their
repayment prospects were better. Another consequence was a growing belief that “house prices would
continue to rise rapidly for the foreseeable future,” write economists Paul Willen, Christopher
Foote and Kristopher Gerardi in a paper for the Boston Federal Reserve Bank. As this notion took
hold, it was “not surprising to find borrowers stretching to buy the biggest houses they could and
investors lining up to give them the money.”

By the logic of rising prices, housing was a fail-safe investment. Homeowners would reap huge
profits from higher values. Lenders would earn interest and, in case of default, be protected
against losses by increased prices. These ideas created a “collective self-fulfilling mania,” argue
Willen, Foote and Gerardi. Credit standards were eased; permissive practices — sloppy, reckless and
sometimes illegal — grew. But they were more consequence than cause of the housing boom, which lay
in the mass psychology of prolonged prosperity.

This is a subversive theory, because it implicates millions of Americans and deprives us all of
a self-righteous sense of victimization. Good events conditioned us to have bad expectations.

Until the bubble burst, few understood what was happening. Fed Chairman Ben Bernanke recently
admitted that he was caught completely off guard by the crisis. But the Obama administration holds
S&P to a higher standard. There must be villains, and they must be punished. Someday this case
may be settled. But for now S&P is a scapegoat, and the Department of Justice has become the
Department of Blame.